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Is Anybody Still Interested in Volatility\?

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Is Anybody Still Interested in Volatility?

If it seems to you like we've been beating on the topic of volatility for forever, I apologize. If it is any consolation, we are nearing the end of this educational path -- at least to the degree that I can guide you. Since we've been covering other issues for the past few weeks, I needed to scan back through my old articles and see where we left off. I was amazed to see that we began this educational process on the option Greeks more than 3 months ago! When I started down this path, I had no idea that I had so much to say on the topic. For those of you just joining us, you can go to the Option Investor site and look in the Options 101 archives beginning with the January 16th, 2002 article. For your convenience though, I've pasted the links to each of the articles in the series below. Aren't I a nice guy? (BIG GRIN!)

Paying Attention to Option Pricing
The Greeks, Part 1 - Delta and Gamma
Application of Gamma and Delta to Strike Selection
Back to the Olympians of Old
Oh, That Vexing Volatility
Volatility - Part Deux
The Greeks - Putting It All Together
A Greek Encore
Varying Views on Volatility
A Primer on Online Volatility Tools - Part I
A Primer on Online Volatility Tools - Part II

That's a lot of writing (for me) and a lot of reading for you. Now that you're up to speed with the old stuff, it's time to dive into the complex use of Volatility that I've been promising for more than a few weeks, that of Volatility Skew. But before I get started, I must doff my hat to a fellow trader and former writer in these pages, Lee Lowell. Lee resides in the sunny Aloha state (makes you envious, just thinking about it, eh?) and as I've gotten deeper into the details of how to apply volatility studies to more complex trading strategies, I've had to rely on Lee to keep me headed in the right direction. He has likely forgotten more about Volatility than I'll ever know, so Lee, if you're listening, thanks for your time and patience!

Alright, on with the show!

We've spent a fair amount of time looking at volatility using online sources, so I'm not going to reiterate how to find the information we're going to focus on here. Rather, I'll point you to the articles listed above, as all the "How To" information is located within.

What Is Volatility Skew?
In an ideal world, all of the various strikes for a given option series (either puts or calls) will have the same volatility. But as you and I both know, we don't live in an ideal world. Volatility levels end up being different both for different strike prices and for different expiration months.

If we were so lucky as to get an ideal example with what we would call a flat skew, here's what it would look like for a $50 stock with a nominal implied volatility (IV) of 55%.

Calls:
Strike   40    45    50    55    60    65
IV(%)    55%   55%   55%   55%   55%   55%

Puts:
Strike   30    35    40    45    50    55
IV(%)    55%   55%   55%   55%   55%   55%
That's pretty boring, but we have to start somewhere. No matter what strike we select, the IV will be 55%. Where things get a bit more interesting is when we have different IVs for different strike prices, creating a simple "sloping skew". This effect normally occurs in more volatile stocks and here's what the IV picture would look like for the same $50 stock with a sloping skew.
Calls:
Strike   50    55    60    65
IV(%)    51%   54%   58%   63%

Puts:
Strike   35    40    45    50
IV(%)    61%   58%   54%   51%
You can see that as the call strikes increase from the ATM strike, so does the IV of the options. Likewise, as the put strike decreases from ATM, the IV rises. And if we listed more strikes for both the puts and calls we would very likely see that the "sloping skew" becomes a "smiling skew" as shown below.
Calls:
Strike   35    40    45    50    55    60    65
IV(%)    61%   57%   53%   51%   54%   58%   63%

Puts:
Strike   35    40    45    50    55    60    65
IV(%)    61%   58%   54%   51%   54%   57%   62%
If you use your imagination, you can see that a graph of volatility (using either the puts or the calls) relative to the strike price will produce a "smiling" shape, from which the skew pattern gets its name. For those of you (like me) that have a rather poor imagination, here is what the graph would look like for the calls.

It doesn't take much imagination to see where the Smiling Skew gets its name, now does it. Unless I miss my guess though, you're all champing at the bit asking the following question: "So what the heck am I supposed to do with this information?". I'm glad you asked, because utilizing this information on volatility skew can dramatically skew (sorry, I couldn't pass that one up) the odds of success more sharply in our favor. This topic will be of particular interest to those traders that prefer to trade using various spread strategies.

I wrote several articles late last year detailing how and when to use various spread strategies, but now that we are armed with this information on the skew effect, we can utilize it to improve our trading results yet again. I think we've gotten far enough into this discussion that you understand the basic premise behind the skew. Besides, most traders find this sort of information rather dry and uninteresting (Big Mistake!) and as we get deeper into the topic, I want to keep our weekly visits brief and easy to process. There's no need to try and go through everything in one sitting.

Next week, we're going to abandon the sterile hypothetical example and tackle a real live stock with a smiling skew. Then we'll look at how utilizing the volatility skew can enable us to place a spread trade with reduced risk and enhanced opportunity for profit.

With a teaser like that, I know I'll see you next week!

Mark

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